Understanding the Increased Tax Benefits of Retirement Planning Under the TCJA

Revisiting the contributions individuals make to tax-deferred retirement plans can make sense in light of the 20% qualified business income (QBI) deduction enacted under the 2017 Tax Cuts and Jobs Act (TCJA).

The QBI deduction is generally available to eligible taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers. The deduction is phased out when taxable income falls between $315,000–$415,000 for joint returns and $157,000–$207,500 for other taxpayers and is lost completely when taxable income exceeds the upper threshold amounts.

The deduction is generally equal to the lesser of (1) 20% of qualified business income plus 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income or (2) 20% of taxable income minus net capital gains.

Consider Steve and Sally who operate a law firm together that expects to generate $440,000 in business income in 2018. All of this business income is considered “specified service business income” under section 199A of the tax code. After claiming a $24,000 standard deduction, Steve and Sally are dismayed to learn that they do not qualify for the QBI deduction since their service business income ($440,000) and taxable income ($416,000) are both over the $415,000 limit. Their federal 2018 income taxes (not including self-employment taxes) are $96,979.

With some good advice, Steve and Sally learn that if they create a 401(k) plan, they can contribute $50,500 into each of their accounts. By lowering their taxable income to $315,000 ($440,000–$101,000–$24,000=$315,000), Steve and Sally now qualify for the maximum QBI deduction ($315,000 x 20% or $63,000). Their 2018 tax bill is now $49,059, a decrease of $47,920 in 2018 income taxes. For those with higher incomes, there may be additional types of retirement plans that provide for greater contribution amounts.

Given that business income is reduced by the standard or itemized deductions, it is often the case that the QBI deduction cannot be fully used. In certain situations, there is a potential opportunity to make Roth IRA conversions without paying taxes on the whole amount by tapping into the unused portion of a QBI deduction.

Consider Michelle and Eugene who are joint owners of a bicycle shop. Their shop is expected to generate $180,000 of business income in 2018 and they will earn an additional $5,000 of dividend income and recognize $10,000 of capital gains from their joint brokerage account. The couple’s qualified service business income is $180,000 and their adjusted gross income is $195,000. Michelle and Eugene are also eligible for a $24,000 standard deduction, which results in a tentative taxable income of $171,000.

Their QBI deduction is calculated as 20% of the lesser of (1) their qualified service business income of $180,000 or $36,000, or (2) their adjusted taxable income of $161,000 (tentative taxable income less the $10,000 capital gains) or $32,200. Taking the lesser of the two per the guidelines, Michelle and Eugene are limited to a QBI deduction of $32,200 — thereby leaving $3,800 of deduction on the table.

Increasing their capital gains does not help because capital gains are excluded from taxable income in the QBI calculation. However, Michelle and Eugene could take a full QBI deduction of $36,000 by completing a $20,000 Roth IRA conversion. The additional $20,000 in IRA income would increase their adjusted taxable income to $181,000. After the Roth conversion, Michelle and Eugene are now potentially eligible for the full QBI deduction of $36,000 since their qualified service business income is now lower than their adjusted taxable income. The additional $3,800 of QBI deduction that they can claim effectively lowers the income tax attributable to their Roth conversion.

For many, the combination of the QBI deduction and retirement planning may offer opportunities to lower taxes and/or tax rates for the next eight years. In addition, the added benefits of adding monies to retirement accounts that grow tax-deferred and which may be subject to lower tax rates or tax-free on future withdrawals make these planning strategies too good not to investigate further.

For additional information on retirement planning and the QBI deduction please see: